Stock and bond markets have looked richly valued for several years. Until recently, those rich valuations have existed without overt evidence of euphoria. It now feels (and that is admittedly not a precise verb) like a boom. A Da Vinci painting changes hands at half a billion dollars. Bitcoin surges more than 1000% since January to over $11,000 earlier this week. We’ve discussed Bitcoin in previous letters, but suffice it to say that what certainly appears (another wonderfully squirrely verb) to be a mania has now reached far into popular awareness. Ugly Christmas sweaters now proudly feature Bitcoin. Katy Perry discusses cryptocurrencies with Warren Buffett, and then memorializes the event on Instagram to over 200,000 likes. What perfect illustrations of pop culture mind share gained by Bitcoin this year!

Enough about Bitcoin, how about certain junk bonds yielding less than Treasury bonds? How about historically low levels of volatility and Goldman Sachs pointing out last week that US market valuations currently sit at their highest since 1900 (see chart below).

Booms can go on a while and this one certainly may. In fact, from a general economy and well-being sense, we probably should hope for exactly that. Obvious warning signs do pose a challenge to us investors. On the one hand, we would certainly prefer to be averaging into investment positions that are generally and historically undervalued. However, those conditions are rare and while we will certainly exploit those when available, in the meantime we shouldn’t simply be out of the market. It is far too easy to see a perceived overvaluation and sell, only to miss another 50-100% upside. The market doesn’t particularly care about our perceptions of general valuation. It only matters what everyone else thinks. As we’ve seen in recent low interest rate and central bank quantitative easing (QE) driven markets such conditions can continue to grow even more extreme for a while. The ultimate frustration lived out by many would-be market timers, is to correctly see overvaluation, sit patiently on the sidelines, and then miss the buying opportunity because things never got “cheap enough”. The odds of consistently guessing right that many times in a row are minimal and better left to the gamblers.

Far better is to consistently seek relative value at all times and maintain a properly balanced and risk-adjusted portfolio capable of taking advantage of market opportunities that periodically arise. To demonstrate this, we’ve going to use the recent example...

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR. INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS. ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

Much of the nation has been transfixed in recent days by the destruction wrought by Hurricane Harvey, its 50+ inches of rainfall, and the ensuing record flooding. Harvey will probably end up being the most expensive natural disaster in American history at an estimated cost of around $200 billion. "You had the greatest rainfall ever measured in the continental United States" said Dr. Joel Myers, Accuweather's founder and president. In addition to the damage to houses, businesses, and automobiles (1,000,000 vehicles are estimated to have sustained flood damage!) Harvey also hit the distribution supply chain across the country, affecting the countries largest port and an estimated 10% of all truck shipments nationally. We would not be surprised to see these recent weather events contribute to some upward pressure on general price levels in future months.

Meanwhile, recent economic data points have been strong. The latest revision of US second quarter GDP was for 3% growth (above estimates). Business and consumer spending is strong (and recovery and restoration spending related to Harvey will likely add to this and increase the general spending level in the economy). The headline unemployment rate continues to decline with a current reading of 4.3%.

The US Federal Reserve seems reluctant to hike interest rates too aggressively, in large part due to perceived "weakness" in overall price levels as measured by the CPI and PCE. The normally newsworthy Jackson Hole central banker meeting was quiet this year. However the combination of strong spending, possible constraints on the supply of goods and materials (including importantly gasoline), and an increasingly tight labor market might change things at some point. Gold was strong (+4%) and is now up more than 10% on the year. Many of the industrial metals have moved upwards even more with aluminum (+10%), palladium (9%), platinum (7%) and copper (+7%) leading the way. Copper is shown below. After experiencing years of weakness beginning in 2011, the economically sensitive metal has reversed trend and is now rising strongly.

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR. INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS. ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

Imagine a bathtub full of rubber duckies. Most of them are bright yellow and cheerful eyed with permanent Mona Lisa beaks. But perhaps there are a few other colors, shapes, and sizes mixed in. Maybe, if this particular bathtub is anything like the one I remember my kids playing in, there are a few plastic sharks, whales, and maybe a penguin or a platypus thrown in for good measure. My favorite was always the wind-up scuba diver flippering along endlessly intrigued by who-knows-what under the bubbles. Regardless of the particulars of the floating toys, when you turn on the bath water they all float. Water in, duckies up. Water out, duckies down.

Asset prices and money (credit) behave in much the same way. When there is more money around, assets appreciate (expansion) and when there is less money around, assets depreciate (contraction). Money in, prices up, Money out, prices down.

This is obviously a simplification excluding the longer term human factors in the economic process (namely innovation and population growth). However, it serves our purpose as a way to visualize boom and bust market dynamics. An booming market can defined as the value of the stuff (stocks, bonds, real estate, money markets) people own going up relative to the size of the economy (GDP) and a bust defined as the inverse. This ratio (Household Net Worth to GDP) is shown in the following chart well over half a century.

Household Net Worth to US GDP

During the period of 1945 to the early 1990's the price of assets (measured in units of economic production) remained range bound. Measured this way, asset valuations gradually rose into the early 1960's, fell as inflation became pronounced and eventually peaked in 1980, and then rose again ending entire fifty-year period close to where they began.

However, since the early 1990's the credit and market cycles have been particularly pronounced with asset valuations rising substantially overall with sharp corrections during the recessions following the tech stock boom of the late 1990's and the housing bubble culminating in the Great Recession of 2008- 2009. Over the past 25 years, aggregate asset valuations rose over 40% according to this measure.

Going back to our rubber ducky analogy, the household net worth line in the chart above is similar to the rise and fall of the floating toys (e.g. prices of stocks, bonds, real estate) in the bath. Why do they go up and down? Because of the amount of water (money/credit) in the tub.

A boom is created by a combination of available money (money, debt, credit are fairly interchangeable) and a reason (a narrative or story) to buy. There are almost as many ways to measure amounts of money and credit in our modern economic system as there are economists. Certain types of credit and debt instruments have become much more liquid and increasingly used to buy assets at the macro (Inter-bank) level. We'll use treasury securities, government agency securities (Fannie Mae mortgage securities for example), and Federal Reserve credit. The prevailing narrative depends on the period.

In 1990, there were about $2.5T of Treasury Securities, $1.5T of Agency Securities and $340B of Federal Reserve Credit. These three sources added up to $4.25T, or 71% of GDP. A decade later, at the end of 2000, the total stood at $8.34T or 81% of GDP (Treasury $3.36T, Agency $4.35T, Fed $635B). The narrative of that era was American Technological Dominance. This was the era when the Cold War was one, when America displayed overwhelming military force in Iraq (Operation Desert Storm), when the personal computer became ubiquitous, and the Internet was born. Confidence and optimism abounded. Booming markets fueled by credit growth certainly didn't hurt.

And then the technology bubble burst, resulting in widespread bankruptcies among Internet, telecom, and technology companies. The result ultimately was large stock market losses (particularly the richly-valued technology stocks), and a US Fed determined to rapidly drop interest rates (at the time the prominent Central Bank tool) and "reflate" the markets.

The chart below shows the course of Federal Reserve interest rates over the same time horizon as the net worth chart from before. This shows the Fed's efforts to react to recessions (the grey bars on the chart) by lowing borrowing rates aggressively. A critical aspect of our analysis is that there is no free lunch in economics and no way to "print to prosperity". Deliberate intervention in markets carries a cost even if that cost is not immediately recognized.

Effective Federal Funds Rate

In 2002 economist Paul Krugman, Nobel prize winning professor of economics at MIT and Princeton wrote about the difference between typical economic fluctuations and credit boom-bust dynamics. He even specifically called for the Fed to create a housing bubble to replace the Nasdaq bubble! The following is a direct quote from his "Dubya's Double Dip" article written in August 2002 in the New York Times, "The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble. Judging by Mr. Greenspan's remarkably cheerful recent testimony, he still thinks he can pull that off."

The housing bubble was indeed created. As all good replacement bubbles must, it exceeded the previous bubble in scope. Toward the end of the mortgage finance and housing price bubble in 2007, Treasury securities exceeded $6.0T, Agency securities had surged to $7.4T and the Fed's balance sheet chipped nearly another trillion dollars at $950B. The total then stood at $14.4T or 99% of GDP.

The narrative shifted to the American Dream of Home Ownership (also plausibly named "Real Estate Always Goes Up"). With mortgages easy to obtain and rates declining, the lure of gains and fear of missing out combined with widely availability of real estate financing to drive prices upwards. Eventually rising interest rates and declining affordability slowed the boom. A recognizable characteristic of credit booms is that when the growth ends, a bust follows.

We know what happened next. In 2007, the housing bubble popped and credit growth turned sharply negative as one lender after another approached bankruptcy. The Federal Reserve repeated its burst bubble prescription, recently learned in the early 2000's, and turned again to forcing interest rates lower and encouraging credit growth. This time though, lower interest rates and optimistic talk weren't encouraging enough. The FASB accounting standards board changed rules to no longer require banks to value their credit portfolios at market prices and the Fed created a new tool. Called Quantitative Easing (QE), Central Banks led by the US Fed began creating money to purchase bonds and other credit instruments. These efforts stopped the bust in its tracks,and got credit growing again by early 2009. As shown below, heavy Central Bank money creation and asset purchases have been a persistent feature of global financial markets ever since.

Global Quantitative Easing (QE)

What has unfolded in monetary and credit terms since early 2009 is astonishing. As of the end of 2016, Treasury securities had reached $16.0T. Surviving the mortgage bubble bust (Fannie Mae and Freddy Mac insolvency and receivership), and returning to growth, Agency securities stood at 8.52T. The Fed’s balance sheet ended 2016 at $4.43T. Again, the replacement credit boom has exceeded the preceding credit bust. The total of these sources of credit now stands at nearly $29T or 156% of GDP.

Household Net Worth to US GDP

Today's narrative is Interest Rates Will Stay Low (as will inflation and economic growth). This story points to continued scarcity of yield (earnings, cash-flow, profits, and dividends) and the unfortunately common refrain in today's financial media that There Is No Alternative to investing in common stocks even as richly valued as they admittedly are.

It is futile to try to predict exactly when and how the market's prevailing winds will shift, but history shows us that nothing lasts forever. With recent coordinated efforts by Central Bankers to inch rates up and rein in asset purchases (QE), the initial steps may now be taking place.

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR. INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS. ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

Oil prices shrugged off OPEC's bullish announcement last week as the Organization of the Petroleum Exporting Countries (OPEC) agreed to extend its production cuts for nine months (through March 2018) at its semiannual meeting. The agreement was generally expected given prior meetings and comments from various countries involved. The cuts, representing about 2% of global supply, come mostly from Saudi Arabia and its Arab member nations, as well as a few nonmember nations, most notably Russia. The extension had been broadly communicated in recent days and oil was down after the news broke as some market participants likely expected a bigger cut or a longer extension into mid-2018. Much of the weakness in energy prices has been due to the surprising (to some) rebound in American production even in light of $45 $55 oil. This production growth is coming from both shale oil and increasingly offshore oil.

Improvements in offshore oil production technology are driving the cost of deepwateroil production in a similar fashion to the way fracking and horizontal drilling drove down the cost of shale oil production. According to Wood Mackenzie Ltd, pumping crude from sea beds thousands of feet below water is turning cheaper because producers are implementing cost improvements and streamlining operations in core wells. That means oil at $50 a barrel couldsustain some of these projects by next year, down from an average breakeven price of about $62 in the first quarter of 2017 and $75 in 2014, the energy consultancy estimates.

The falling production costs make it more likely that investors will approve pumping crude from such large deepwater projects, the process for which is more complex and risky than drilling traditional fields on land. That may compete with OPEC’s oil to meet future supply gaps that the group sees forming as demand increases and output from existing wells naturally declines. Over the next three years, eight offshore projects may be approved with breakeven prices below $50, according to a Transocean Ltd. presentation at the Scotia Howard Weil Energy Conference in New Orleans in March. Eni SpA could reach a final investment decision on a $10 billion Nigeria deepwater project by October.

While costs for shale production, known as tight oil, are edging higher now, expenses associated with deepwater drilling are finally coming down. Rental rates for drilling rigs have been cut in half since 2014, and companies are redesigning projects to be more cost efficient instead of to maximize output.

According to Fitch Group’s BMI Research, deepwater exploration will see “renewed momentum” over the rest of 2017 as large integrated oil companies look to capitalize on lower service costs and strengthening fiscal positions. In the U.S. Gulf of Mexico, a more costefficientdesign for deepwater projects has reduced the breakeven cost at many wells to below $40 a barrel.

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR. INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS. ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

The most important price in the world is the price of money because it affects the price of everything else. How much does it cost in the future to get enough money to buy that tractor now? A farmer knows how much more corn he’ll get by having a newer, larger tractor. He knows the value of the tractor, but the price he’s able to pay depends on the interest rate. The price of money.

If the farmer decides to buy the tractor now, he’ll improve the productivity of the farm. The tractor maker will show a profit and hire more workers. Those tractor workers will buy cars to get to work. The car maker will show a profit and hire more car workers. Those workers will buy houses. You get the point. Lots of good things will happen in the economy if our favorite farmer decides to buy a tractor.

But there is a small catch. He will pay for that tractor in the future. The tractor he buys today means he can’t buy one next year. There is no free lunch. Sandwiches do cost money and the sandwich we eat today can’t be eaten tomorrow. Tractors are similar. But, the interest rate, will determine when the farmer buys the tractor and at what price. By way of example, if he qualifies for a 72 month 0.9% interest only loan, he will likely decide differently about that $100,000 tractor, then if he must come up with $10,000 in interest each year.

We write all that about farming and tractors to say this. The United States is the center of capitalism for the whole world. However, the very most important price, the price of money, is set by a committee sitting in a dark, smoke filled room. Seriously. Okay, it’s 2017 so the room is probably neither dark, nor smoke filled, but the effect is the same. The unelected Federal Reserve sets the most important price in the world by mandate.

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR. INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS. ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.